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WASHINGTON, Sept 3 (Reuters) - Google Inc should develop a privacy policy for its plan to digitize millions of books that limits use of consumer data, the Federal Trade Commission said in a letter to the company.

Google's project to scan libraries full of books has been stalled by a copyright infringement lawsuit filed in 2005 by the Authors Guild and publishers. A New York court will hold a hearing on a plan to settle that lawsuit on Oct. 7.

The settlement has been attacked from a variety of angles, one of them being concerns that the privacy of people accessing books through Google could be compromised.

In a letter to Google dated Thursday and posted on the FTC's website, the agency urged the search engine giant to develop a new privacy policy for Google books and to focus on "limiting secondary uses of data collected through Google Books, including uses that would be contrary to reasonable consumer expectations."

Secondary uses of data refers to a practice like using a list of books read in order to decide which advertising to show a Google Books user.

"We also agree that it is important for Google to develop a new privacy policy, specific to Google Books, that will apply to the current product, set forth commitments for future related services and features, and preserve commitments made in the existing privacy policy," wrote David Vladeck, director of the FTC's Bureau of Consumer Protection.

In a separate statement, FTC Chairman Jon Leibowitz said his agency would press for consumer privacy to be protected.

"The Google Books initiative could provide a wealth of benefits for consumers, yet it also raises serious privacy challenges because of the vast amount of user information that could be collected," he wrote.

As part of a settlement of the copyright infringement lawsuit, Google has agreed to pay $125 million to create a Book Rights Registry, where authors and publishers could register works and receive compensation.

Under the settlement, authors have until the end of this week to opt out of the settlement.

The proposed settlement has been criticized by Google's rivals, Amazon.com, Microsoft and Yahoo, and by privacy advocates.

The American Library Association and Association of Research Libraries have asked for court oversight. They fear that if the service becomes a necessity for libraries, they would face monopoly pricing.

The U.S. Justice Department is investigating the deal for possible antitrust violations while European Union antitrust enforcers, prompted by Germany, have said they would study it.

The case is Authors Guild et al v Google Inc 05-08136 in U.S. District Court for the Southern District of New York (Manhattan). (Reporting by Diane Bartz; Editing by Tim Dobbyn)